Asia Insight

November 2008

Download Asia Insight
Quarterly Fund Fact Sheets

Asia’s Headlock of Conventional Wisdom

Robert J. Horrocks, PhD
Director of Research
Matthews International Capital Management, LLC

Asian stock markets are caught in the headlock of conventional wisdom. They have been moving in lockstep with the U.S. consumer for so long that it has become conventional wisdom that they must always do so. Only on two occasions over the past 20 years have the two parted company. During the Asian financial crisis, Asian markets plunged while the U.S. consumer went on a buying spree. The second time that Asian markets moved in a different direction from U.S. consumer sentiment was just briefly in late 2007 at the height of the “decoupling” argument. The U.S. consumer was clearly deteriorating as Asian markets headed for all-time highs. As we now know, the U.S. economy was crumbling rather rapidly. “Decoupling,” at least as its advocates painted it, was an illusion.

For good measure, an old-fashioned liquidity crunch has also hit Asian markets. This has been particularly apparent in Korea, where its currency, the won, dropped dramatically. The decline did not quite revert to the 1997 crisis levels but fell by enough to remind the region that it is still dependent on U.S. dollar-denominated funding. The U.S. acts as the region’s banker by recycling Asian savings: Asia owns very safe short-term assets in the U.S. and the U.S. owns longer-term, riskier assets in Asia. This is the classic model for a bank—borrow short and lend long. Since the capital base of the “USA Superbank” has been deteriorating, funding has begun drying up in Asia, exacerbated by the lack of a deep local bond market. Despite the funding crisis and slowdown in external demand, the kind of havoc wrought during the Asian financial crisis seems unlikely to occur for several reasons: a lack of debt in regional economies, reasonably robust financial systems, fast growth, improving corporate management and supportive demographics.

A key linkage during the crisis—excessive debt—is absent. Asian countries have less than 40% of GDP in foreign debt, and China (11%) and India (19%) are among the lowest. Loan-to-deposit ratios in Asian banking systems are low and range between just 60-80%—with the exceptions of Korea at 130%, Australia at 120%, India at 105% and Thailand at 100%. Asia’s listed companies do not have massive debts and Asian companies carry large reserves of cash on their balance sheets.

Final sales demand in Asia’s economies should be more resilient than in the past. It can be easy to forget how big Asia is—on purchasing power parity terms¹ the Asian consumer is already slightly larger in aggregate than the U.S. consumer. What’s more, the rate of growth is much quicker. Every year, new final sales demand in China approximately matches that of the U.S. in dollar terms. Even though the U.S. is a much bigger economy than China, China’s growth is much faster (10% versus 2%) and its currency is appreciating. The balance of marginal spending in the world is shifting.

The impetus behind this growth is Asia’s own industrial and consumer evolution—a long-term trend that is not likely to fade. The productivity of the Asian worker continues to rise, even as the U.S. falters. The International Monetary Fund also recognizes the growth of the emerging economies as a group, forecasting that these economies will maintain growth above 5% while the growth of developed economies slows dramatically. This was not the case in the past—emerging economies struggled to show an appreciably better rate of growth in aggregate than developed ones between 1982 and 2002.

Improving Demographics

Demographic changes impact the economy and asset markets, and may offer long-term predictive transparency. One such study² shows a telling relationship in the number of 40–49 year olds in a population divided by the number of 20–29 year olds. The theory is that as the proportion of middle-aged workers rises, so, too, do returns on equity, stock valuations and stock prices. The causation lies in the fact that those in their 40s are at their peak earning power and are most motivated to save for retirement, whereas the younger age group tends to spend money, make less and also save less. The study tracked the demographic ratio for the U.S. through history and into the future, showing a significant decline beginning around the turn of the 21st century. This decline has coincided with weaker economic and stock market performance in the U.S. Updating the study and expanding it to Asia³ shows a very different trend for economies of the East. For Asia, this ratio troughed in the early 1990s and is set to continue rising through 2050.

The willingness of the forty something savers to support a high P/E ratio may be further backed by institutional changes in Asian countries to establish pension fund schemes, such as the MPF in Hong Kong, and the new systems under development in Korea and China. Alongside these government-led changes, the Asian mutual fund industry is already developing regular savings plans that use equity mutual funds as savings vehicles rather than tools of speculation. If the same relationships hold true in the future as they have in the past, then returns on equity should continue to be supported in Asia even as they disappoint in the U.S.

We know that returns on equity in Asia have risen dramatically over the past 10 years. For the broad universe of Asian stocks, the core return on equity for Asian companies has risen from little more than 10% in 1997 to over 15% now.⁴ Previous peaks in this return have not exceeded 13.5% using the same dataset. This performance is all the more remarkable since average gearing ratios have fallen (because debt can be used to gear up the balance sheet and increase returns on equity). Clearly a part of the stronger performance is the synchronized global expansion that we have enjoyed: however, both margins and asset turns have improved, and this may be the sign of a more structural change. Managers are generating more sales per unit of assets—they are “working their businesses harder.”

Short-term Government Support

Government stimulus should not be seen as a driver of long-term economic performance; yet, there can be much to do to support growth in the short run. In the U.S., this ability is constrained by a budget balance of –2.5% of GDP. In Asia, only India, Malaysia, Pakistan, and Thailand compare unfavorably on this metric; China has a budget surplus. In addition, we have seen recent announcements from both the China and India central banks that they are moving from a tightening policy to a looser monetary policy. China has relaxed its quotas on credit, allowing the banks to lend more freely; India has announced cuts in policy rates and, less conventionally, established lending facilities for banks and mutual funds. Owing to the healthy state of corporate and household balance sheets in Asia, there will be a greater demand for funds than may be seen in the U.S., where paying down debt remains the key concern.

So, for the investor who worries about Asia “getting the flu” if the U.S. “catches a cold,” the reality may be different. Certainly, Asian economies will slow down. And yes, there is still a large degree of linkage between our markets. However, history never repeats itself exactly—the unexpected does happen.The crisis this time is focused on the U.S., with its high debt levels and deteriorating demographic profile. Asia, on the other hand, is debt-light, with no systemic banking crisis, and demographics that support economic growth and market returns over the long term.

The markets in the short term are driven by conventional wisdom. For the moment, that means that as the U.S. falls, so Asia must descend with it. However, I see a potential excess reward to patience and confidence in Asia, one of the world’s fastest-growing regions.

1 Dollars adjusted for buying-power in an economy.
2 Demography and the Long-run Predictability of the Stock Market, John Geanakopulos, Michael Magill, and Martine Quinzii, 2004.
3 Boomers and Markets, CLSA Asia Pacific markets, September 2005.
4 FactSet Research Systems

The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.